We just started offering health savings accounts (HSAs). If a customer cashes a check (for any reason) using their HSA, and the check is returned, can we offset the returned check amount against the HSA funds? Would that be a nonqualified distribution? Our account agreement holds the customer responsible for checks deposited in the HSA that are returned unpaid, but we do not deposit these checks when cashing them. We use IRS form 5305-C for our HSAs, which are custodial accounts.

No, in our view, your bank should not exercise a setoff against funds in an HSA account for a check that it cashed for its HSA customer which subsequently was returned for insufficient funds.

In general, under Illinois law, the right of setoff can arise contractually when a deposit account or loan agreement provides for a right of setoff, or it can be based on common law when there is a “mutuality” of parties and a matured debt (for example, a loan that has become due or has been accelerated). For a traditional deposit account, your bank likely could exercise its common law right of setoff because of the mutuality of ownership between the account and the debt owed to the bank due to the returned check. Your traditional deposit account agreements also most likely include a provision creating a contractual right of setoff that would permit this.

However, the IRS model HSA account agreement states that “[n]either the account owner nor the custodian will engage in any prohibited transaction with respect to this account (such as borrowing or pledging the account or engaging in any other prohibited transaction as defined in section 4975).” (The IRS model form for trust accounts contains identical language referencing a trustee’s responsibilities.) Because the withdrawal of HSA funds for a nonmedical expense would be a prohibited transaction, we believe that exercising a right of setoff on the HSA account for an unrelated check returned NSF would violate this restriction.

For resources related to our guidance, please see:

IRS Form 5305-C, Health Savings Custodial Account (“Neither the account owner nor the custodian will engage in any prohibited transaction with respect to this account (such as borrowing or pledging the account or engaging in any other prohibited transaction as defined in section 4975).”)

IRS Form 5305-B, Health Savings Trust Account (“Neither the account owner nor the trustee will engage in any prohibited transaction with respect to this account (such as borrowing or pledging the account or engaging in any other prohibited transaction as defined in section 4975).”)

Internal Revenue Code, 26 USC 223(d) (“The term ‘health savings account’ means a trust created or organized in the United States as a health savings account exclusively for the purpose of paying the qualified medical expenses of the account beneficiary, but only if the written governing instrument creating the trust meets the following requirements: . . . The trustee is a bank (as defined in section 408(n)), an insurance company (as defined in section 816), or another person . . . .”)

Internal Revenue Bulletin 2008-29 (July 21, 2008):

(“Q-35. If a trustee of an HSA lends money to the HSA, is this a prohibited transaction under § 4975?

A-35. Yes. An HSA is a plan as defined in § 4975(e)(1)(E). An HSA trustee is a disqualified person under § 4975(e)(2). A loan or extension of credit between a plan and a disqualified person is a prohibited transaction. Section 4975(c)(1)(B). Thus, any direct or indirect extension of credit between the HSA trustee and the HSA is a prohibited transaction.

Example 1. Bank X is the trustee of an HSA. Bank X extends a line of credit to the HSA. The line of credit is a prohibited transaction under § 4975.

Example 2. Bank Y is the trustee of an HSA. The account beneficiary accesses the funds in the HSA through a debit card. In addition, Bank Y extends a line of credit to the account beneficiary, which is not secured by the account beneficiary’s HSA, and amounts in the HSA cannot be used to repay the line of credit.

The line of credit is not a prohibited transaction.”)